The ECB Sticks to the Gameplan

Today's interest rate action was not particularly difficult to call as both the BOE and the ECB moved (Q&A here) in as expected to keep interest rates on hold. Actually, given the BOE's initial response to the credit turmoil á la the Fed with the intention to lower interest rates today's decision has to be seen as somewhat of a u-turn. Obviously, this may turn out to be a wise one (or not) depending on how inflation data pan out in the next couple of months and quarters. Turning to the ECB the decision to keep rates on hold comes in the context of the mother of all dilemmas as the ECB tries to fight the un-fightable in the context of a steadily increasing economic slowdown (with notable divergent trends) and rising headline inflation. I have, on several occasions, been kicking the ECB for not recognizing the downside risks to economic growth and especially for not realizing the unsustainable asymmetries created as a result of the ECB standing its ground in the context of the very aggressively cutting Fed. I still maintain that bias and in this way it is one thing to disagree with Bernanke's policy but quite another to not respond upon how the surrounding world acts. So far however, the ECB has been vindicated in the context of rapidly increasing inflation globally which is also showing up in the Eurozone indices where the y-o-y HICP rate is running far above the threshold deemed comfortable at the ECB. It could thus seem as if the Fed has provided the world with plenty of liquidity to go around and certainly enough for commodities and food to have shot up (although I am far from convinced that all this can be blamed on the central banks).

Yet, the curtain may soon fall for the ECB as economic realities impinge on the objective to maintain price stability. It is pretty obvious that Spain, Italy and Ireland are now all three slowing rapidly. This is not necessarily bad in the context of Spain and Ireland where almost a decade worth of brisk growth had to come to an end but in the context of the former the boom/bust dynamics look set to become very severe indeed. Furthermore, Italy is now set to painfully conform to all those claims heralding the country as the sick man of Europe. I still think that Italy represents a risk to the stability of the global financial system which is wholly unpriced into the general market movements and it is precisely in this context that I have been rather critical of the recent six months' rally in the EUR/USD. However, in terms of cyclical observations it has long been clear that the ECB would not move unless material evidence of a slowdown in Germany emerged. Domestic demand has long been stagnant and declining but that has been countered by an impressive growth in exports and as a derivative industrial production (corporate capex). In this light, the recent news that both exports and industrial production declined in March is not at all insignificant (neither of course is the corresponding news from France).

The ECB is not likely to lower rates come next meeting in June. For this to materialise we would have to see a significant turn for the worse in terms of German data as well inflation also should show signs of abating. On the former account I think we might very well see a considerable deterioration (see also Sebastian Dullien here) although April compared to March is likely to show a pick-up. This is mainly due to the fact that if you add the numbers for March only the PMI for services showed a slight expansion. This means that Germany may have contracted in March. This will of course be verified once we get national accounts for the Eurozone but it is clearly significant in terms of those aiming for a growth rate of 0.75% in Q1. The EUR/USD is now hovering a tad bit lower than its previous highs of 1.59-1.60 currently trading at around 1.54-1.55. The reasons for this slight fall from grace could be many but most prominently has been a discussion about whether foreign central bank reserve managers sold out a bit at 1.60 seeing that the main source of the global economic instability was the falling USD and its contribution to global inflation; much more about this here as well as at Brad Setser and MacroMan.

In summary, the ECB retains its inflationary bias in the face of growing and lingering headline price pressures. The dilemma however has not gotten any smaller in Frankfurt where the ECB is now presiding over a stagflationary economy with notable divergences between the member states. In all likelihood the ECB will stay pat come next meeting in June. A below consensus Q1 GDP reading, a material slowdown in Germany, and abating inflation pressures could pave the way for a cut already in June. This is very unlikely at this point though. Conversely, if inflation picks up considerably pushing the HICP towards the 4% mark and if Germany stays resilient a hike cannot be ruled out. For the record I, as well as most commentators, see a middle position and thus a holding operation.